Be wary of rich payouts from these two mining giants

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It's hard not to salivate at the lush dividends on offer from global miners BHP Billiton Ltd. and Rio Tinto PLC.

Both are paying an 8-per-cent or higher yield and both declare they won't cut their payouts – just the opposite in fact. The two companies keep reassuring investors that they can stick to a "progressive" policy of regularly increasing dividends, in large part because of their privileged positions as low-cost producers of iron ore.

Unfortunately, as you may have guessed, there are problems with this happy picture. Investors who are tempted to buy a slice of the two miners' rich payouts may first want to read a new report on global iron ore production from analysts at Citigroup.

James Bennett and his team begin by offering up the consoling thought that it is difficult to see the spot iron ore price falling below $30 (U.S.) a tonne for very long. That is only about $8 below current levels, which suggests the devastated market is finally nearing a bottom, even if it's not quite there yet.

For investors who have seen iron ore slide from $190 a tonne back in 2011, any sign of stability would be welcome. However, things become more complicated when you examine the all-in cost curve for the industry, including both production and freight costs.

An all-in cost curve shows how much it costs each miner to produce and ship the stuff. By Citi's calculations, only three companies make up the entire lower half of the all-in cost curve for iron ore.

Rio, BHP and their Brazilian competitor, Vale SA, are the small group of miners that can produce iron ore for less than the global average cost. Fortescue Metals Group Ltd. of Australia makes up the next quartile in terms of cost of production.

"Very worryingly, this means that every other producer makes up the fourth quartile," the Citi analysts write. Among the miners saddled with iron ore production that is uncompetitive at current prices is Anglo American PLC, the erstwhile giant that is now trying to reduce its size by two-thirds as it grapples with falling commodity prices.

The big three iron ore miners are much better situated on the cost curve, but happiness is relative. The Citi analysts calculate that the length of time it takes a new iron ore project to pay back its costs has skyrocketed from 18 months at the giddy height of the recent cycle to around 20 years now. There is little incentive for any producer to embark on new projects.

There is also decreasing motivation to pay out money to shareholders. The all-in cost analysis ignores the cost of dividends, since those are regarded as a discretionary cost.

If you factor in the cost of paying a dividend, BHP's cost per tonne of iron ore soars by more than $25, while Rio's surges by at least $15. As the Citi analysts note, this moves BHP and Rio from being the world's lowest-cost producers to the highest cost, since many of their peers don't pay a dividend.

Investors should take note. "This analysis … questions the strategy of BHP Billiton and Rio, who are adamant that they are the low-cost producers and therefore should run flat [out], as they will be the 'last man' standing and others will be forced to cut first," the Citi analysts write.

If the Citi analysis is correct, investors who buy Rio or BHP on the theory that those two giants can use their superior size and low costs to cudgel rivals into submission may wind up being the ones getting hammered instead.

"In this commodity environment … to actually execute this strategy [of producing at capacity to drive rivals out of the industry] … both companies would have to cut their dividend – suggesting that their shareholders will wear more pain than their competitors," the analysts conclude.